Does the Market Understand Time Variation in the Equity Premium?

Posted: 4 Aug 2022 Last revised: 13 Jan 2023

See all articles by Mihir Gandhi

Mihir Gandhi

University of Chicago - Booth School of Business

Niels Joachim Gormsen

University of Chicago - Booth School of Business

Eben Lazarus

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: December 23, 2022

Abstract

We test whether the market has intertemporally consistent expectations about the log equity premium. We use option prices to estimate the expected future equity premium (the forward rate) and compare this to the equity premium estimated in the future (future spot rate). Forward rates are strong predictors of future spot rates, suggesting that the market qualitatively understands variation in the equity premium. The market does, however, make predictable and quantitatively significant forecast errors. To match the data, we propose a model in which an increase in the equity premium causes investors to overestimate the future equity premium.

Keywords: asset pricing, expected stock returns, rational expectations, diagnostic expectations, time-varying discount rates

JEL Classification: G10, G12, G40

Suggested Citation

Gandhi, Mihir and Gormsen, Niels Joachim and Lazarus, Eben, Does the Market Understand Time Variation in the Equity Premium? (December 23, 2022). Available at SSRN: https://ssrn.com/abstract=4170950 or http://dx.doi.org/10.2139/ssrn.4170950

Mihir Gandhi

University of Chicago - Booth School of Business ( email )

5807 S Woodlawn Ave
Chicago, IL 60637
United States

Niels Joachim Gormsen (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Eben Lazarus

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street, E62-633
Cambridge, MA 02142
United States
6173247036 (Phone)

HOME PAGE: http://elazarus.mit.edu

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
2,337
Abstract Views
1,481
Rank
9,514
PlumX Metrics